Bracing for a Fall

A screen that I run semi-regularly on Value Line identifies stocks priced under $10 that have one of the service's two highest rankings. As a portfolio, this list has nearly doubled the market rate of return for more than 20 years, albeit with gut-wrenching volatility. It has been a tremendous source of undiscovered growth stocks and turnaround candidates.

But when I ran the screen in September, I was surprised to find only nine stocks. The list usually has about 25, and when the number is well below that, it means the market is approaching a topping or choppy period. Today, I found just six on my list of low-priced stocks that have high ranks for revenue and earnings growth potential. In addition, it was an entirely new list with no names repeated. This is highly unusual, so I went back to see what happened to the previous nine stocks. I expected to find that they had appreciated sharply and were no longer in the single digits. What I saw was exactly the opposite.

As third-quarter earnings reports flooded in, most of the previous list fell short of expectations or had outright declines in revenue or earnings growth rates. The stocks did not appreciate, but the fundamentals deteriorated to the point that the companies no longer qualified for the screen. Seven of the nine stocks fell off the screen because of declining business and finance conditions, not because they traded above $10. I don't recall seeing this condition with the list of Value Line 1 and 2 rankings under $10 in the 12 years or so I have been tracking this screen. This raised a red flag, so I looked at what else the service has downgraded lately. The downgrade list has kept me out of certain sectors that were set up for a fall, and it has helped me to decide to sell stocks that have appreciated and are due for profit-taking.

One thing that stood out immediately is the service has downgraded many retailers. The consumer appears to be pulling back, and even the strongest names are seeing slowing sales and earnings momentum. The first and biggest name on the list is Whole Foods (WFM). The stock slipped from a ranking of 1 for year-ahead performance as momentum has slowed. Earlier this month, the company issued guidance that fell short of expectations and the stock slipped from a 52-week high. This was before the grocer announced it would likely take a one-time charge in this quarter to account for damage from Hurricane Sandy. The business is also vulnerable to the fiscal cliff and economic weakness, so consider taking money off the table with this highly valued stock.

Many retail and consumer-oriented names are on the downgrade list. Strong performers such as Under Armor (UA), Carters (CRI) and Ross Stores (ROST) lost top-tier rankings as momentum slowed. Saks (SKS) fell another notch and ranks poorly for the next year. Even consumer powerhouse Walt Disney (DIS) fell to the middle of the pack. Other downgraded names this past week include Children's Place (PLCE) and Dollar General (DG).

This wholesale downgrade of retail and consumer stocks is another red flag. Momentum is coming out of the financials, and that often leads to a shift in stock-price momentum. As we head into what many believe will be a period of high volatility going into year's end, it's time to prune your retail and consumer stock holdings. If we go off the fiscal cliff, these names will lead the way lower as consumers are hurt by a new recession.

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